The New Boundries of Diversification: As companies balance growth with focus on their key strengths, they are more broadly defining their core capabilities. (Honing Supp)

When McDonald’s Corp. recently unveiled its first Golden Arch hotel, near the Zurich airport in Switzerland, the move left some people scratching their heads, wondering what the burger giant could possibly be thinking by expanding into the lodging business. Yet others say that the expansion is hardly unexpected, given that profits have been flat in the fast-food business. Facing diminishing growth in their core businesses, McDonald’s as well as other companies are looking for ways to extend their enterprises and leverage their core competencies in new business areas. The days of empire-building conglomeration in which companies acquired an array of unrelated businesses are long over, but companies’ forays into new businesses raise questions regarding core competencies and the nature of diversification today. How can you tell the difference between logical business extension and diversification beyond core capabilities? Companies face market, earnings, and other pressures that require them to continually hunt for potential complementary additions to their existing core businesses which can come through internal growth, such as McDonald’s has done in developing its hotel concept, or through external growth via merger or acquisition. At the same time companies also feel pressure to concentrate their resources and efforts on core businesses. Since the early 1990s, companies have been restructuring in order to pare down their holdings to a more focused portfolio of businesses. The two potentially conflicting pressures to stay focused yet grow have prompted companies to start looking at their core competencies in a new way, say bankers and business consultants who help clients identify their strengths, establish viable business strategies, and explore growth alternatives. A business extension that years ago would have been labeled a diversification play today could be viewed as solid business strategy, they say. As more and more companies strive to balance growth with maintaining a tightened focus on their key strengths, they are more broadly defining their core capabilities and exploring avenues of growth in areas that years ago might have been considered outside of their area of expertise. McDonald’s Golden Arch hotel provides a good example. While running a hotel is different than running a restaurant, there is a whole set of operations that it takes to run each of those businesses, and perhaps there is similarity between those operational processes even though the businesses are different, says London-based Justin Jenk, head of m&a-Europe at Accenture, formerly known as Andersen Consulting. “A big part of running a hotel involves service and taking care of people. McDonald’s may have looked at its capabilities and decided that while preparing and serving fast food has been its fundamental strength, more broadly it is good at serving people in a highly cost-effective manner,” he says. “The company might even be interested in getting into the catering business within its hotels, or in ensuring that there is a McDonald’s in each of its hotels. That would help stimulate business, because there is a certain core process in being able to serve people.” The dilemma that McDonald’s faces, Jenk adds, is that it realizes it is reaching its limits in opening new restaurants. “There are only so many Big Macs that someone will eat,” he says. Seeking other sources of revenue in the increasingly competitive fast-food market, the company moved beyond its mainstay burger business and acquired a stake in Chipotle Mexican Grill in 1998. The following year it bought Donatos Pizza, a Columbus, Ohio-based chain of pizza parlors, and Aroma Ltd., a British chain of coffee and sandwich shops. The market value of a company is driven by growth, Jenk notes, and while a company may be achieving strong margins by staying in its niche, after a certain point the “growth dynamic” in the sector will disappear. “The company will have to get cleverer in re-segmenting or penetrating that existing market in order to extend that growth dynamic,” he says. In Jenk’s view, diversification is done solely to protect cash flows and balance out risks. He says that he is strategically focused and tends to view a company’s core competencies very broadly. For instance, while some people might have viewed Enron Corp.’s transformation from a gas pipeline system operator to an energy services and fiber-optic network construction company as diversification, Jenk believes that company has progressively built on its capabilities without losing sight of its core competency. “To me, that is not a willy-nilly set of diversifications. They have thought through what their core capabilities are, how they can extend their core business, and what growth options are available to them. Their bet in broadband, I suspect, is that they believe that they’re good at laying and managing networks and figure that they can build on their capability of installing gas networks. Diversification? No. Core business today? No. A growth option for the future? Yes.” Gas companies, Jenk says, provide another good example. Many gas companies now operate convenience stores at their gas station locations. While gas exploration, production, and retailing is a different business than convenience store operation, Jenk says that he does not view that as diversification, but rather as an add-on business. “That, to me, is growth,” he says. While some people might consider McDonald’s expansion into the hotel business or Enron’s move into broadband as a bit of a stretch for the companies, Kenneth H. Wiexel, a Partner in the Merger and Acquisition Services Practice at Deloitte & Touche, says, “One person’s diversification is another person’s business strategy. Sometimes you read articles about companies moving into new businesses and you wonder what the connection is, because on the surface, it doesn’t look like it’s related. It might appear to be diversification when in fact it’s not. It’s also a matter of perception,” he notes. His clients, he says, are mainly strategic buyers and sellers that have very disciplined m&a strategies which are interwoven with their business strategies, and he says that he can not recall having worked with a client that has diversified just for the sake of diversifying. Colleague Gregg Smith, a Partner in the Corporate Finance Practice at Deloitte & Touche, says, “We work with clients that analyze their relationships with one or two key customers and try to figure out how they can become a little more vertical with those customers. When we look at a company’s core strategy, we might see some diversification within a certain customer base, for example. Some people might wonder how that fits in with a company’s capabilities. It’s really playing off the strengths of a company’s relationships, but I wouldn’t consider that diversification” he notes. Robert Filek, Transaction Services Leader for Multinational Clients at PricewaterhouseCoopers, agrees. He says that companies today strive to hold leadership positions in their markets, and they define their core businesses based on markets in which they can hold the number 1 or number 2 position. As part of that focus, more companies also are defining their core businesses around their customers and pursing a “customer-centric” m&a strategy, as they realize that customer needs is a key consideration in setting strategy and gaining a competitive advantage. Focusing core competencies on customer relationships Customer focus is a key element of Tyco International Ltd.’s growth strategy, says the company’s CFO, Mark Swartz. Today, companies need to be more nimble and flexible in order to react to quickly changing markets and business environments, and thus must more broadly define their core competencies, he says. “While at one time having manufacturing expertise in a certain line of products would have been a broad enough core capability, now you also need to have a relationship with your customers that allows you to know what their future needs are going to be and an understanding of the changing dynamics in your marketplace. For those reasons, I believe you need to have many core competencies as opposed to being narrowly focused,” he adds. Swartz’s company has been successful in executing a diversified growth strategy – based largely on acquisitions – that leverages manufacturing capabilities in five product areas, including electronic components, undersea fiber-optic cable, and disposable health care, fire and security, and flow control products. Tyco focuses on being both the low-cost producer and a leading supplier in each of its markets. And although his company operates in a wide range of businesses, Swartz says that it is much more focused than it was years ago. “When I look at companies that grew years ago through diversified strategies, they were interested in any type of business that added to the earnings of their existing businesses. We are acquisitive, but we are not looking at acquisitions just for growth’s sake,” he says. CEOs and investment bankers continually present acquisition opportunities to Tyco that would add to the company’s earnings or cash flows, but only for a year or two, he says. “We are looking for businesses that are going to make us stronger three, four, five years from now, not for a quick increase in earnings. Of every 10 acquisitions we look at, we pass on nine of them. If a deal is not going to make us stronger and build on our core competencies, we’d rather walk away from it now rather than allow it to slow us down in the future,” he adds. Tyco’s more broadly defined areas of capability, Swartz says, would include new technologies, customer service, superior management style, and acquisition and integration of businesses. All of Tyco’s core competencies are focused on strengthening its relationships with its customers, Swartz notes. “Part of our success in each of our businesses stems from our customer service capability. A number 1 or number 2 market position doesn’t stand on its own. Your company has to be perceived by your customers as filling their needs,” he says. His company’s recent acquisition of CIT Group Inc. is a perfect example. For years the company had been considering adding a financing arm to its mix of businesses in order to help its customers with their finance needs, Swartz says. While Tyco has not been looking to increase the number of businesses that it operates, it is looking to strengthen its existing units and sharpen its customer focus, he notes. There is clearly a trend today toward companies reviewing their assets and re-thinking them, says Filek. Not only must a company decide which of its businesses to grow but also which to divest because they no longer leverage the company’s key strengths. But although there is nothing to say that a company shouldn’t be able to run a number of businesses under the same corporate umbrella, he adds, the stock market historically has liked pure-plays. Ultimately, what is going to make an acquisition or investment successful or not successful is whether a company is putting its proven capabilities to work, not what Wall Street thinks, says Jack Kelly, a managing director at Goldman, Sachs & Co. who follows the multi-industry stocks and heads up the firm’s U.S. industrial group. The acquisitive companies that he follows look far beyond any short-term reactions that the stock market has on their deals, he notes. The companies focus on doing strategic acquisitions, executing successful integrations of those businesses, reaping the synergies that the deals have to offer, and operating the companies profitably, he says. Kelly shares the view of many consultants and bankers that companies today are more intent on building market share in businesses that they know than in venturing into entirely new markets. Following the wave of corporate restructurings over the past several years, a line of strategy that he calls “focused diversity” has emerged, he says. The diversified companies that he studies particularly are expected to adhere to the “focused diversity” growth model and target internal growth and “bolt-on” acquisitions that are complementary to their core competencies, he says. Carefully defining your “opportunity space” While companies generally are advised against diversification done solely to achieve revenue growth or scale, organizations that too narrowly define their capabilities might be missing out on good growth opportunities, says Mark Sirower, head of the m&a practice at The Boston Consulting Group. “One of the first things I do when I do an acquisition search is to define the company’s opportunity space, because we want to clearly understand what capabilities we are building on. Sticking to your knitting’ can hurt a company if it has not carefully considered what its opportunity space is,” Sirower states. Jenk agrees with Sirower. “I think people are feeling cautious right now, because of the economic environment, which is a pity. It would be shame to think that companies that are confident about where they are heading and feel that they have done what they can organically within their current markets aren’t looking for opportunities right now.” Reprinted from the May 2001 issue of Mergers & Acquisitions Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com